Jonathan Crowther, Head of UK LDI at AXA Investment Managers, analyses why the price of inflation hedging has fallen and what this means for UK pension schemes.

“There is an interesting opportunity for inflation hedging today. Buying inflation protection is relatively cheap, and the price of hedging inflation risk has drifted down this year and is near the lowest levels seen since early 2013. At the same time, there is a lack of inflation linked bond supply coming up, and pent up demand for hedging from LDI users and those who may have been held back by the uncertainty of the Scottish referendum”.

“This means that there is potential upside for long-dated inflation break-evens. If nominal yields do rise from their current macro-fear driven lows, then by buying inflation protection now and hedging nominal rates later, pension schemes could potentially achieve real yield hedges at positive real yield levels”.

Why has the price of inflation fallen?“At the long dated end of the market, it is especially true that supply and demand factors drive the market rather than fundamental views on long-term inflation. Where nominal yields fall by more than real yields, then mathematically inflation break-evens are squeezed lower. This is what has happened in 2014. Despite a generally positive economic environment in 2014, international commodity prices have fallen and the market has been gripped by risk aversion arising from geopolitical unrest, driving yields on nominal gilts lower. Index-linked gilts yields have followed a similar path but not fallen by as much, which is why inflation break-evens have been squeezed lower. There was a brief reprieve from the prevailing trend when the bigger fear of Scottish independence became a negative for gilts. However the removal of the uncertainty surrounding the referendum outcome and the Scottish vote to remain in the union has helped yields resume their downward trend”.

LDI demand rises in every Q4 period“In every post-financial crisis calendar year, LDI hedging activity has a habit of rising in the fourth quarter, which has tended to support the RPI swap rate. Although there are currently disinflationary forces at play, weighing down short and medium dated inflation expectations, we expect the long-dated end of the market to continue to be driven by supply and demand factors, and to follow a similar pattern to previous years. The Scottish referendum may even have kept hedging demand at bay in late summer and as a result there might be more pent up demand this year”.

Supply of index linked bonds unlikely to sate market demand“Around £15.2 billion of linkers have been issued so far this financial year, and there are four remaining linker auctions this calendar year which should lead to an additional £5-6bn of supply. This level is however unlikely to sate current demand. For instance, the syndication of the 2058 linker at the end of July was hugely oversubscribed, with £14.5bn of demand for the £5bn that was offered, clearing at a negative yield of 5.3bps. Demand is likely to outstrip supply over the next few months and this should provide good support for long-dated RPI swap levels”.

Higher chance of hedging at a positive real yield“If geopolitical risks abate and the economic outlook remains as currently expected, then we could see a retracing of 30 year nominal gilt yields back to the levels seen at the beginning of the year, over 3.7% per annum. Schemes buying inflation protection at the current levels of around 3.50% and able to hedge at nominal yields above this level would achieve a positive real yield. Real yields are unlikely to retrace back to the same extent, and it is likely that taking a phased approach to building a real hedge provides a greater chance of capturing a positive real yield”.

Does inflation-only hedging reduce risk?“One question that arises is the impact an inflation only hedge has on the risk profile of a pension scheme. Paradoxically, inflation hedging increases the certainty of what amounts are to be paid by the scheme in respect of inflation linked pension payments, but does not reduce uncertainty regarding the value placed on inflation hedged real liabilities. This means the inflation protection bought does not always feed through as a reduction in a scheme’s ‘value at risk’ measure”.

“Nevertheless, many schemes may still see a reduction in risk. This would be either because they have hedged interest rate risk and not inflation, either through corporate bond holdings or targeted LDI hedging, or because they have room to increase their inflation hedge beyond their nominal hedge given the characteristics of their overall portfolio and risk appetite. For these schemes, now may be a good time to buy inflation protection.”